As China Sneezes, Will the World Catch Cold?

Over the past three years, there's been a remarkable transformation in global perceptions about the sustainability of Chinese growth. As Europe faltered and the U.S. fought a massively oversupplied housing market, China managed to sail through difficult global economic conditions and seemingly avoided the difficulties that ensnared much of the West. In 2010, the world was convinced that Chinese economic growth would save the world. China had grown to become the world's second largest economy and many extrapolated this trend to the day that China would be larger than the United States. Few questioned this belief, and investors titled their portfolios towards assets that would fare well in a world of strong continued Chinese growth.

The sustainability of China's high growth rates is now being questioned, and with good reason. Headline GDP growth was 7.6 percent in the most recent quarter, the sixth straight quarter of slowing growth. Chinese officials at the highest levels regularly comment today about measures to support continued growth. Benchmark interest rates were cut in June and July, and while real estate markets have recently demonstrated some resilience, prices remain - on average - below last year's levels and inventories are noticeably high. Recent earnings reports from multinational corporations continue to confirm the official data: China is slowing, with significant implications.

The credit-fueled investment boom is ending, with serious ramifications for the supply-chain to China. The short of it is that China has simply built too much stuff, and while it will eventually need the currently empty malls, buildings and infrastructure - one can even add entire cities to this list! - demand for the raw materials used to build them will plunge. Given that approximately 75 percent or so of recent Chinese GDP growth has come from capital investing, building less stuff in China has the potential to cut growth rates to the low- or mid-single-digit range.

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Vikram Mansharamani

China

While the list of casualties may be quite long, three of Wall Street's favorite investments appear particularly vulnerable; two other expected "casualties" may actually stumble through without much pain.

As a result of its building boom, China has had a domineering influence on the market for industrial commodities. The magnitude of Chinese demand on selected industrial commodities is noteworthy: more than 60 percent of global demand for cement and iron ore, more than 40 percent for steel and aluminum in 2011. Inspired by strong growth in demand for their products over the past several years, many mining companies have embarked on multiyear expansion projects - with an underlying assumption of continued growth in Chinese demand.

Reduced demand from China combined with expanded supply will lower prices. Consider iron ore, selling for ~$50/ton in 2007. In 2011, it was trading for ~$200/ton at one point and was recently quoted ~$110/ton. If the Chinese building boom busts, demand for iron ore, a key input in steel-making, will surely plunge. Iron ore could revisit the ~$50/ton price point, if not lower. In general, however, it's conceivable that India and other emerging markets could pick up the slack capacity of what are fundamentally scarce resources in the long-run - more than 5 years).

Australia, in particular, is in the cross-hairs of a slowdown in Chinese investment spending as it's a major supplier of key industrial commodities - bauxite, alumina, gold iron ore, lead, zinc, uranium, aluminum, brown coal and more. Years of strong growth from China have also led to a continued influx of immigrants participating in the booming mining business, resulting in inflationary pressures in both labor and housing markets. Many of the Australian mines have expanded to meet an expectation of continued Chinese demand growth.

The risk of commodity weakness infecting Australia's banking and housing finance system is quite high because most mortgages are kept on the books of banks. Investors should exercise caution when investing in Australian assets -- be they equities, debt, or even the Australian dollar (Figure 2). As a relatively high-yielding option in a low-yield world, Australian sovereign debt has benefited from strong inflows of yield-hungry capital. Mid-single digit yields, sufficiently attractive to date, may not appear adequate in the face of currency declines exceeding the yield.